Central Banking - Beyond Inflation Targeting. (1)

Andrew Smithers
Beyond Inflation Targeting - Policy Exchange, 25th September 2009

Our current troubles are the result of inept central banking arising from two errors, for which the Federal Reserve was the most prominent but by no means the only proponent.(2) The first was to claim that the value of equities and other assets could not be known and the second was to claim that falls in asset prices, if they were to occur, could be readily offset by monetary policy.

In 2002 Stephen Wright and I wrote a paper explaining why the Federal Reserve should adjust its policy, not only in the light of expected inflation but also if stock market prices reached excessive levels. But at that time we doubted whether “this view would yet receive support from the majority of economists”.(3) . As I write today, it is quite hard to find economists who disagree. Opinions tend to be moved more quickly by events than by arguments, and this change is no doubt the result of financial turmoil and the dramatic loss of output in the real economy. Among central banks, the ECB has already acknowledged that central banks need to take asset prices into account when setting monetary policy.(4) and there are encouraging signs that even the Federal Reserve has decided to reconsider its attitude.(5)

Asset prices are an important transmission mechanism whereby changes in interest rates affect the real economy, but these changes are ephemeral. If monetary policy is too easy for too long, asset prices are temporarily driven a long way above their fundamental values and the strength of their mean reversion becomes stronger than the influence of interest rates. We know from recent experience that when this happens central banks lose control of their economies. Massive fiscal stimulus and unusual monetary policies then become necessary and the risks of both inflation and deflation rise.

To avoid a repetition of our current troubles, central banks will need to identify which asset prices matter, how to value them and what steps to take before they reach excessive heights.

The assets which matter are equities, house prices, and the return which investors receive from holding illiquid assets, which I will loosely term the “price of liquidity”. Central banks must understand how to value each of these and they will therefore have to overcome the confusions that result from the residual influence of the Efficient Market Hypothesis (“EMH”). Although its invalidity has been known for some time, economists have been slow to put a new paradigm in its place. This is a habitual problem(6) and has given rise to the unkind comment that “Science advances obituary by obituary.” While recent events are likely to accelerate the internment of the EMH, we are left with some residual difficulties. Although economists have generally discarded the EMH, the habits of thought that went with it often remain. A frequently encountered example is the assumption that the equity risk premium can sensibly be used for valuing assets or predicting returns, despite the evidence for its instability. There is also a risk that the justified reaction against the EMH will go too far. Instead of assuming that financial markets are perfectly efficient, there is a growing tendency to assume that they are simply irrational casinos.

If markets are perfectly efficient, there can be no difference between price and value and if price changes are wholly irrational, then value has no effect on prices and thus no practical relevance. No rational analysis of the prices of assets relative to their values can thus be made on the basis of either of these two extreme views. There is also ample evidence against them, as stock markets appear to be imperfectly efficient systems in which prices revolve around their equilibrium values. We are therefore experiencing a paradigm shift in which the EMH is being replaced by an “inefficient market hypothesis”, which has had two necessary parts. The first was to show that existence of value around which prices rotate is, unlike the EMH, a testable hypothesis.(7) The second was to provide a rational explanation as to how share prices diverge from their equilibrium values and develop the momentum which accompanies these changes.(8)

I am optimistic that investors and the financial press are becoming increasingly aware of the ways in which stock markets can be sensibly valued despite the nonsense regularly published on the subject, particularly but not only by investment bankers. Good progress has also been made with regard to the valuation of the other key asset prices. House prices have received a lot of attention in recent years(9) and the work suggests that housing bubbles can be identified. The price of liquidity, whose importance I have also emphasised, has also been given prominence by the Bank of England.(10)

It is increasingly accepted that central banks must not ignore asset prices, as the recent announcement by the ECB shows. As the valid criteria for valuing assets become more widely understood, the debate will increasingly focus on the levels at which action should be taken to restrain their excesses and the steps that should be taken. Even when we have achieved a greater degree of agreement on these issues than we have today, central bankers will still need to exercise judgement when deciding whether or not the stock market, house prices, or the price of liquidity are approaching a dangerous level. The evidence suggests, however, that these judgements are much less difficult than those which central banks are currently required to make, such as the size of the “output gap”. It is generally agreed that, in the absence of swings in inflationary expectations and the impact of changes in international prices, inflation will tend to fall if an economy is operating with a positive output gap and rise if it is without one. Judging whether, at the current level of output, there is a positive or negative gap is thus extremely important for central banks, but it has also been shown to be extremely difficult.(11)

Once it has been accepted that central banks can monitor the difference between the value and the price of assets, the next step is to consider the policies that should be implemented should they get out of line. The concern with asset prices must not replace the aim of stabilising consumer prices, but should be an additional responsibility. Although the failure to address asset price bubbles is the cause of our current troubles, the introduction of inflation targeting by central banks has been a considerable success and we should not go backwards and discard the valuable advances that have been achieved.

If central banks have only one policy instrument, namely short-term interest rates, the only possible response to asset bubbles is to “lean against the wind”, as suggested by Lucas Papademos, Vice-President of the ECB,(12) and Sushil Wadhwani, former member of the Bank of England’s Monetary Policy Committee,(13) among others. This requires central banks to raise interest rates in response to asset prices when this would not seem justified by the outlook for consumer prices over the usual policy time horizon. Had this been the policy of the Fed during the bubble that developed in the late 20th Century, it seems likely that the stock market would not have risen to the heights it did and the Federal Reserve would not have needed to reduce interest rates then as much as it did in order for the US economy to recover from the 2001 recession, which followed the sharp fall in the stock market. The subsequent recovery would then have been of a more traditional and orderly kind and the second round bubbles which broke in 2007 would not have occurred. In the nature of things we cannot prove what might have been. Whether or not leaning against the wind would have produced a better outcome for the economy must therefore be a matter of judgement. What can be said, unequivocally, is that the actual outturn of events, which followed very different policies by the Federal Reserve, has been of a kind that we will wish to avoid if possible in the future.

It would, however, surely be better to add another policy instrument to the central banks’ armory. One possibility, which seems to me to be the best so far proposed, is that central banks should have the power to vary commercial banks’ minimum capital ratios. This has been proposed as a way of offsetting the tendency of banks to exaggerate cycles(14) but, as this problem is associated with the rise and fall of asset prices, there is no conflict in using it also as a way to dampen asset prices and the two objectives are in particular harmony when one of the asset prices under consideration is the liquidity price, as this indicates when lenders have become by past standards, insufficiently risk averse. It is in just these conditions that a constraint on excessive ease in bank lending is clearly desirable.

My conclusions are therefore that central banks must, in the future, be concerned with asset as well as consumer prices and that they should be given an additional policy weapon, so that they have two weapons as well as two targets. I would, however, caution that this does not mean that the economy can be managed without periodic recessions. It seems to me to be likely that by responding to asset as well as consumer prices, it should be possible, though difficult, to avoid major recessions; it is probable that periodic mild recessions are the minimum price that we must pay to avoid major ones.


(1) The issues discussed in this article are examined much more fully in Wall Street Revalued - Imperfect Markets and Inept Central Bankers by Andrew Smithers, which is due to be published by John Wiley & Sons, Ltd. in July this year.

(2) For the former views of the current Chairman of the Federal Reserve’s Board of Governors See Monetary Policy and Asset Price Volatility by B. Bernanke and M. Gertler published in the Federal Reserve Bank of Kansas City Economic Review 1999 4th Quarter pp 17 – 51.

(3) World Economics Vol. 3 No. 1 Jan-Mar 2002 Stock Markets and Central Bankers – The Economic Consequences of Alan Greenspan by Andrew Smithers & Stephen Wright.

(4) See ECB favours using monetary policy as asset-price tool article in the Financial Times 15th May, 2009.

(5) As reported, for example, in “Troubled by bubbles” by Krishna Guha in the Financial Times 16th May, 2008.

(6) As famously formulated by T.S. Kuhn, notably in the Structure of Scientific Revolutions University of Chicago Press 2nd edn. 1970 first published 1962.

(7) See Valuing Wall Street by Andrew Smithers and Stephen Wright. McGraw Hill March 2000 and Wall Street Revalued – Imperfect Markets and Inept Central Bankers by Andrew Smithers op. cit footnote 1.

(8) See An Institutional Theory of Momentum and Reversal by Dimitri Vayanos & Paul Woolley, The Paul Woolley Centre Working Paper Series No.1 FMG Discussion Paper 621. November, 2008.

(9) For example, A Spatio-Temporal Model of House Prices in the US, by Sean Holly, M. Hashem Pesaran and Takashi Yamagata, (2008), forthcoming, Journal of Econometrics.

(10) Decomposing credit spreads by Rohan Churm and Nikolaos Panigirtzoglou Bank of England Working Paper No. 253 and Lewis Webber and Rohan Churm Decomposing corporate bond spreads Bank of England Quarterly Bulletin 2007 Q4 page 233.

(11) The difficulty of this decision is well set out in a paper by Athanasios Orphanides and Simon van Norden on The Unreliability of Output Gap Estimates in Real Time. CIRANO November 2001 and subsequently in 2002 in the Review of Economics and Statistics, Vol 84, pp. 569-583.

(12) See footnote 4.

(13) Wadhwani Sushil, Should Monetary Policy respond to Asset Price Bubbles? Revisiting the Debate. National Institute Economic Review No. 206 October, 2008.

(14) See The Fundamental Principles of Financial Regulation by Markus Brunnermeier, Andrew Crocket, Charles Goodhart, Avinash Persaud and Hyun Shin op.cit.